A Debt Strategy For the Next 30 Years

Dec 3, 2012

This article first appeared in Business Horizon Quarterly, a publication of the National Chamber Foundation.

The United States is on an unsustainable fiscal course. This year marks the fourth in a row that the U.S. federal deficit will exceed $1.1 trillion. Since the end of 2007, the federal debt, now $11 trillion, has doubled as a share of annual GDP—from 36% to 73%. The long-term outlook is even worse.

The deficit is likely to improve in the next few years, but it will then turn upward again due to the projected rise in federal spending on Medicare and Social Security. According to the Congressional Budget Office (CBO), spending on those two programs will rise from 8.7% to 12.2% of GDP by 2037.

The good news is that U.S. lawmakers and policy experts from across the political spectrum have begun in earnest to outline possible strategies for tackling this looming debt crisis. Unsurprisingly, many suggestions—from the Left and the Right—are misguided or not particularly constructive. For example, a number of left-leaning think tanks have recently supported a “financial transactions” tax that would cause huge distortions, raise far less revenue than projected, and push more of the industry offshore. Similarly unhelpful, some conservative groups have advocated abolishing various small spending programs on the grounds that such cuts will improve the fiscal outlook, even though their elimination would have only a trivial impact on the overall federal budget.

Given the plethora of ideas being floated, it is critical that policymakers—both liberal and conservative—zero in on a framework that effectively addresses our fiscal challenges and permits specific policies to be properly evaluated. Outlined below are three key principles that are essential to this endeavor and offer concrete policy applications based on these principles. First let’s provide some context for understanding the size of the problem.

Understanding the National Debt

The gross magnitude of the federal deficit and federal debt is incomprehensible to most citizens. One way to put the debt burden in a more digestible framework is to compare the borrowing levels appropriate for a household to those of the government.

The conventional personal finance advice is that one’s mortgage should not exceed three to four times one’s annual income. This rule of thumb can be adjusted depending on expected future income growth, interest rates, or other expected expenses, but it is a reasonable starting point. For example, a household earning $100,000 would be well advised to buy a house for no more than $375,000–$500,000, assuming a 20% down payment.

The government’s income, total taxes, are expected to be $2.4 trillion this fiscal year. Given that the federal debt is $11 trillion, the government’s debt is already more than four times greater than its income. If the debt-to-GDP ratio rises to 200%, as CBO forecasts for 2037, the situation changes dramatically, with the debt-to-income ratio rising to more than 10. This would be the equivalent of a family who earns $100,000/year buying a $1.25 million house.

Three Elements of a Successful Debt-Reduction Framework

The key metric is the ratio of debt to GDP, not the absolute debt level. This ratio rises when the federal government’s borrowing is a higher fraction of existing debt than the rate at which the economy grows—that is, when the numerator grows faster than the denominator. If the nominal level of economic growth is 4% per year, for example, then, starting from a point at which debt equals 60%of annual GDP, any deficit above 2.4% of GDP increases the debt-to-GDP ratio. Given the enormous deficits of the last few years, that goal may seem impossible.

On the other hand, from 2001 to 2008, the federal deficit averaged just 1.8% of GDP. While an economic growth agenda alone will not solve our problems, the solution must include growth-oriented policy changes. Our pending debt crisis poses a threat to our country’s ability to continue to grow and prosper. High debt burdens impose high costs, as the annual obligation to service that debt (interest costs) limits our ability to fund other programs or reduce tax burdens.

Critical to any successful set of reforms to tackle the looming debt crisis is a laser focus on the economic growth consequences of policy changes to federal programs, entitlements, and the tax system. In particular, any reforms to the tax system must be structured in a manner consistent with encouraging capital formation and human capital development.

The tax burden on capital income—dividend and capital gains taxes and the corporate income tax—has been shown to discourage investment in the United States and therefore is contrary to a growth agenda. High marginal tax rates on entrepreneurship can also stifle innovation.

Without changes to Medicare, Medicaid, and Social Security, there is no solution. While the level of discretionary spending has spiked significantly in recent years and should be scrutinized carefully, the only real solution to our looming debt crisis comes from fundamentally slowing the growth rate of entitlement, or “mandatory,” spending, which consists primarily of Medicare, Medicaid, and Social Security. Over the last several decades, health care costs have been consistently rising at a rate higher than inflation—about 4.9% per year in real terms between 1965 and 2005. According to CBO, spending on major federal health programs is scheduled to increase from about 5% of GDP to 10% of GDP in the next fifteen years.

Applying the Principles: Establish Policy Objectives

In applying the principles outlined above, policymakers face three questions:

  • What goal should be set for a debt-to-GDP ratio, and in what year should it be met?
  • What level of tax receipts and spending outlays should be targeted to achieve that goal?
  • What tax reforms will promote growth and provide sufficient levels of revenue, and what changes to federal health and retirement spending will reduce Medicare, Medicaid, and Social Security outlays to sustainable levels?

Policymakers need to be realistic in the goals they set and then pursue those goals as aggressively as they can. Reasonable people can disagree over the answers to the above questions but for me, I would give these answers:

  • Deficits today represent the decision to pay for things tomorrow. Therefore, the higher the debt-to-GDP ratio, the more our children will be taxed in the future to finance today’s spending. There is no certain answer to this question, but I recommend setting a goal of achieving a debt-to-GDP ratio of 60% by 2035. The Peterson Institute recently asked think tanks across the political spectrum to develop comprehensive strategies to stabilize the debt-to-GDP ratio. I collaborated with several colleagues at the American Enterprise Institute, and we submitted one such plan called “Fiscal Solutions: A Balanced Plan for Fiscal Stability and Economic Growth.” Though it was by no means a simple task, we limited the debt to 60% of annual GDP in 2035, primarily by curbing the growth of the nation’s entitlement programs.
  • Given changes in the demographics of our country and the difficulty in holding health care spending growth to the rate of the overall economy, tax burdens will likely need to rise. Critical to such a change will be ensuring that as the tax system grows, it becomes more efficient. This means lower effective tax rates—especially the tax rate on capital income—and a broader tax base. Specifically, the corporate tax rate, the dividend tax rate, and the capital gains tax rate should be made as low as possible. The hundreds of tax credits, deductions, and exclusions should also be carefully reconsidered, with many of them repealed, reformed, or otherwise reduced.
  • Addressing entitlement reform in an effective manner is paramount. Simply reducing the payments to health care providers without fundamentally restructuring the incentives for providing affordable, quality care will never yield the desired results. Only by harnessing the forces of competition and the private sector’s ability to respond to incentives will doctors, hospitals, other providers, and patients seek out better, more cost-effective treatments. Incremental change in that direction occurred when health savings accounts were established in 2003. The necessary fundamental change to Medicare is likely to be some version of the “premium support” model, whereby the government provides financial assistance to ensure that all seniors can afford to purchase their own health insurance, much like the concept behind Medicare Part D. Any realistic reform will require those beneficiaries who are able to do so to bear increased costs.

Conclusion

The task of confronting the national debt is challenging, but it is quickly becoming unavoidable. The strategy that I propose here would help policymakers face the problem head on. By bringing the real issue into focus (the debt-to-GDP ratio), policymakers can set accurate, meaningful goals. By emphasizing economic growth, they can avoid creating a growth problem as they solve a budget problem. By being honest about the primary cause of the problem—entitlement programs—they can move to address issues that will only become more painful if we delay.

 

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